Reserve Bank lending rules hit harder than expected

The Reserve Bank's restrictions on the level of mortgage lending with low deposits took more borrowing out of the system than expected, and have helped douse the property market's potential risk to the nation's financial stability.

House sales dropped 11 per cent since the central bank imposed the restrictions on high loan-to-value ratio lending, with a 23 per cent slump in turnover of houses under $400,000. That's more than the bank's estimates of a 3 per cent to 8 per cent reduction in house sales, according to the Reserve Bank's six-monthly financial stability report. The restrictions were estimated to have slowed house price inflation by 2.5 percentage points.

Governor Graeme Wheeler said the country's financial system remains sound and is well-placed to support the economy, though there are still risks emanating from the high levels of debt in the household and dairy sectors.

"Debt in the household sector remains high relative to income, and house prices are overvalued on several measures," Wheeler said in a statement. "As a result, financial stability could deteriorate if there is a sharp correction in house prices, particularly if accompanied by a reduction in debt repayment capacity."

The central bank limited the level of low-equity home loans banks could write from October as a means to take the sting out of a heating property market, particularly in Auckland and Christchurch, without having to resort to early interest rate hikes, which may have fuelled demand for an already elevated currency. Since then, the bank has embarked on a tightening policy, hiking the official cash rate twice to 3 per cent.

The financial stability report said the LVR restrictions appeared to be having the desired effect, and reiterated deputy governor Grant Spencer's comments last week that the bank doesn't envisage removing them until at least late this year. The prospect of rising interest rates had also tempered housing demand.

"Although the LVR speed limit is helping to contain the risk of a sharp housing correction, house prices remain at elevated levels and have continued to grow faster than household incomes," the report said. "Housing demand will likely continue to outstrip supply in the near term, particular with strong net immigration adding to population growth."

Elevated agricultural debt levels, particularly in the dairy sector, were also a risk to the nation's financial stability, as a drop in commodity prices could lead to a fall in land prices and put pressure on highly leveraged borrowers.

"Give the existing indebtedness of the sector, a significant increase in credit growth and farm prices would pose a significant risk to financial stability," the report said. "There are also several potential global shocks, including a disruption in the Chinese economy, which could trigger a more significant decline in commodity prices and a consequent drop in collateral values specifically land prices."

The bank noted there was increased activity in farm sales which could risk higher levels of debt being taken on, while acknowledging farmers had been using strong commodity prices to repay debt.

The report also cited a disorderly correction in Chinese lending and property markets as a risk to New Zealand's financial stability if they increased funding costs for local banks, ad sapped demand for exports.